The Implications Of Negative Yields

by: Ben Emons

At times investors may encounter an awkward phenomenon; a negative yield on a bond. In general yields on fixed rate or zero coupon bonds have no boundary; they could go (theoretically) infinitely negative. Negative yields are no longer uncommon however. Switzerland and Denmark's short-term government bonds yield around -25 basis points or -0.0025%. Treasury bills in Germany, the Netherlands and Austria trade in some specific cases also at a negative yield. Even recently US T-bill rates were briefly negative when Treasury yields rose sharply in June. A negative yield implies a cost to an investor. Earning a negative yield means the price paid for a bond is above par (100). That could be seen as an upfront payment. In the market for T-bills and short-term government bonds this phenomenon has been at work for a while. To take a current example; a German government bond that matures on September 13, 2013 pays a coupon of 0.75%. It is currently trading at a price of 100.13 with a yield of -5.3 basis points or -0.0053%. The bond matures at 100 regardless its yield or price at purchase. Because the investor has paid more than a 100 at a negative return (-0.0053%) and the security has a short maturity (2 months), there is a chance the "cost" paid (-5.3 basis points) could materialize when the security matures.

It is a cost investors are perhaps willing to pay because they see a negative yield as "risk free". Obviously that is not true because the debtor (in this case the German government) has to pay coupon interest (0.75%) to the investor. The security being at a negative yield still has the risk the German government could default on the coupon payment due on September 13th. Another reason why a negative yielding bond is seen as "risk free" is because it is a close substitute for cash. How negative yields could go largely depends on the willingness to pay the cost for holding cash. This has also something to do with expected returns. If expected returns are low, people are willing to accept a low nominal rate of return or even negative return as long as there is an expectation of positive capital gains. In the example of the German bond that matures in September, even at a price of 100.13 and -0.0053% yield, there could still be a positive price return should demand pick up for these securities. That could for example happen when risk aversion among investors goes up. In such moments of distress, negative yielding assets are purchased because they are seen as a "safer" alternative. The negative yield is also the cost investors are willing to pay to have access to liquidity.

In general, one could ask the question whether negative yields matter in any situation as long as there are positive capital gains to be made. To find an answer to that question, one may have to look at equities. The idea of negative rates has not been strange to the equity world. According to CFA Institute Research, equity risk premium in the US has been on average -0.91% from 1965-2007. The negative risk premium implies an equity earnings yield (1 divided by the PE ratio) that is 'persistently' below the yield on government bonds. Both Japan and the US experienced negative equity risk premium that only reversed once a crisis subsided. This has been the case since 2009, and so equity risk premium for the S&P 500 has been a positive 5 percent while equity returns have been very high. Researchers Prescott and Mehra found that in order to reconcile high equity returns, 'negative' earnings yields had no impact on people's decision to invest in stocks, simply as they always expected positive capital gains. This has been dubbed as the 'equity risk premium puzzle'. Their research showed however the premium puzzle was not caused by high equity returns itself, but rather "risk free" rates that stayed low for a considerable period of time.

In fixed income, the expectation of capital gains is for instance expressed by the shape of the yield curve. Also here a 'premium puzzle' is at hand. The slope of the yield curve--measured as the difference between 10-year maturity bond yield and a 3-month T-bill rate--has on average since the 1950s been positive. That positive premium is known as "term premium". It represents a variety of components such as inflation expectations, volatility and liquidity. For an investor buying a fixed income security with a negative yield may not matter as long as the yield curve exhibits positive term premium. The reason is that the slope of the yield curve offers a positive reinvestment return, even if all bonds would be trading at a negative yield. Thus investing in a negative yielding bond, has to answer to one of three definitions of 'term premium': 1) expected return of a zero coupon bond minus a short rate, 2) forward rate minus expected future spot rate or 3) zero coupon yield minus average expected short rates. The answer could be found in the "expectations hypothesis". That theory states the expected return from holding a long bond until maturity is the same as the expected return from rolling a series of short bonds with a total maturity equal to that of the long maturity bond. A "natural limit" is when longer maturity bond yields fall below 0%. Pension funds and other long term investors would conceivably not be able to invest at 0% or less.

The idea of a "premium puzzle" and negative yields is that they are not only caused by risk aversion among investors but currently also strongly influenced by central bank policy aimed at keeping interest rates very low for an extended period of time. For bond investors, facing low or negative yields in short-term maturity bonds means that the slope of the yield curve at least offers some positive return. For fixed income investors, this return has been 'stable' over time which in today's low rate environment continues to play an integral role in investment strategies. A bond or stock investor should seek out a positive term or equity risk premium when the cost of investing liquidity in short-term instruments is high.

Disclaimer: This article reflects the current opinions of the author, and such opinions are subject to change without notice. There can be no assurance that such opinions are or will remain accurate.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.